Question

Jason Craven (JC) Incorporated is a public company that produces and distributes high quality surround sound speakers. The company’s suppliers provide a deep discount if it makes large purchases. As a result, JC’s production volume is often greater than its sales volume for a given period. In 2019, the company produced 120,000 speakers, but sold only 55,000 speakers. The company provides the following cost information:

Variable Cost per Unit
Direct Materials	$12
Direct Labor	$20
Variable Manufacturing Overhead Costs	$8
Variable General and Administrative Costs per unit sold	$5
Annual Fixed Costs
Fixed Manufacturing Overhead Costs	$600,000
Fixed General and Administrative Costs	$35,000

The company uses the cost plus pricing system to determine the appropriate selling price for its speakers. If the company decides to use the absorption cost as the base, the markup percentage would be 25%. If the company decides to use the variable manufacturing cost as the base, the markup percentage would be 35%.

a) Calculate the selling price for each of the two pricing strategies (i.e. using the variable manufacturing cost or the absorption cost as the base).

b) For each of the selling prices calculated in part a), create an income statement to determine income from operations. Which selling price will generate the highest income from operations?

Jason Craven Incorporated
Income Statement
For the Year Ending December 31, 2019

Jason Craven Incorporated
Income Statement
For the Year Ending December 31, 2019

c) The company’s sales manager estimates that the speakers cannot be priced more than $60. At this price, management thinks that they can sell 50,000 speakers. The initial investment in producing the speakers is $1,500,000 and the company’s desires a 20% on return on investment. Using the target costing method, should the company set the price per speaker at $60?

Answer 1

a) Under absorption costing, fixed manufacturing overhead costs is considered as product cost and included in unit product cost.

Fixed manufacturing overhead cost per unit = Total Fixed manufacturing overheads/Units produced

= $600,000/120,000 speakers = $5 per speaker

Calculation of selling price under Absorption Costing (Amounts in $)

Direct Materials	12.00
Direct Labor	20.00
Variable Manufacturing Overhead Costs	8.00
Fixed Manufacturing Overhead Costs per unit	5.00
Total unit manufacturing cost as per absorption costing (12+20+8+5)	45.00
Markup on cost (25%*$45)	11.25
Selling price using absorption cost as base (45.00+11.25)	56.25

Under variable costing, fixed manufacturing overhead costs is considered as period cost and not included in unit product cost.

Calculation of selling price under Variable Costing (Amounts in $)

Direct Materials	12.00
Direct Labor	20.00
Variable Manufacturing Overhead Costs	8.00
Total variable manufacturing cost as per absorption costing (12+20+8)	40.00
Markup on cost (35%*$40)	14.00
Selling price using absorption cost as base (40+14)	54.00

b) Income Statement under both methods are shown as follows (Amounts in $)

Jason Craven Incorporated
Income Statement (Absorption Costing Method)
For the Year Ending December 31, 2019
Sales (55,000 speakers*$56.25)		3,093,750
Cost of goods sold (55,000 speakers*$45)		(2,475,000)
Gross Profit		618,750
General and Administrative Costs:
Variable General and Administrative Costs (55,000 speakers*$5)	275,000
Fixed General and Administrative Costs	35,000	(310,000)
Income from Operations		308,750

Jason Craven Incorporated
Income Statement (Variable Costing Method)
For the Year Ending December 31, 2019
Sales (55,000 speakers*$54)		2,970,000
Variable costs [55,000*(40+5)]		(2,475,000)
Contribution Margin		495,000
Fixed Costs:
Fixed Manufacturing Overhead Costs	600,000
Fixed General and Administrative Costs	35,000	(635,000)
Income or (Loss) from Operations		(140,000)

As it can be seen from the above income statement that selling price calculated using absorption cost as base (i.e. $56.25) will generate the highest income from operations.

c) Desired return on investment = Initial investment*Desired return %

= $1,500,000*20% = $300,000

Target Sales = 50,000*$60 = $3,000,000

Total Target Cost = Target Sales - Desired Return on Investment

= $3,000,000 - $300,000 = $2,700,000

Total Actual variable cost = (12+20+8+5)*50,000 = 2,250,000

Total Actual Fixed cost = $600,000+$35,000 = $635,000

Total Actual cost = $2,250,000+$635,000 = $2,885,000

As the actual cost is more than the target cost, the company should not set the price at $60.